Wednesday, November 30, 2011

Buffett: Credit Default Swaps Potentially "Very Anti-Social" Instruments

In this CNBC interview, Warren Buffett is asked by Andrew Ross Sorkin if he believes credit default swaps should exist.

Well, Buffett points out that, for sound reasons, individuals can't insure someone else's house:

...because you do not have an insurable interest*, as they call it in the trade. Because once you insure my house against fire and you may decide that, you know, that maybe dropping a few matches around my lawn might be a good idea.

He added that with credit default swaps participants benefit if a place gets into difficulty:

...when a lot of people have an interest in a place getting in trouble, they may start putting out misleading statements...if you were short the stock of a bank, you might hire—and there wasn't any FDIC, you might go out and hire 100 movie extras to stand in front of that bank.

And...

...in effect, you would create your own reality. Now buying credit default swaps and talking about them and causing the price of credit default swaps to go up creates its own reality to some degree. So I think that they are potentially a very anti-social instrument.

This was Charlie Munger's take on credit default swaps when the worst of the financial crisis had begun to recede. As usual he's unequivocal. According to this Bloomberg article, Munger says he supports a complete ban so speculators can't profit from the failure of others. 

From the article:

Berkshire's Munger Favors '100% Ban' on Credit Swaps

"If I were the governor of the world, I would eliminate it entirely -- 100 percent...That's the best solution. It isn't as though the economic world didn't function quite well without it, and it isn't as though what has happened has been so wonderfully desirable that we should logically want more of it."

Here's one of many reasons why I won't be holding my breath on something reasonably intelligent being done about credit default swaps (and, for that matter, some other forms of speculation) anytime soon. In this The Atlantic interview (also mentioned in this previous post), John Bogle paraphrases a quote by Upton Sinclair that pretty much sums it up:

"It's amazing how difficult it is for a man to understand something if he's paid a small fortune not to understand it."

So, with that in mind, better to have realistic expectations about whether the most logical financial system changes will happen.

Entrenched interests are "paid a small fortune not to understand" why the casino should be reigned in.

They're also paid to not understand why speculative activities should be kept more separate from the core banking utility function.

Sinclair would understand the forces at work here.

Adam

Related posts:
The Bond Market Rules
Sinking Seaworthy Ships

* Insurable interest is a fundamental principle in the insurance business that came about long ago for some very good reasons. From a historical perspective, it was the United Kingdom that provided leadership in this area. It had been learned the hard way from vast experience the lack of an insurable interest creates moral hazard. They sought to remove the ability to profit from another's loss and the misconduct associated with it. The principle hasn't served us too badly over the centuries. Human nature hasn't changed.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, November 29, 2011

Facebook's IPO: $ 100 Billion Valuation?

This post from back in June looked at Facebook's potential valuation and compared it to some other large technology businesses.

Is Facebook Worth $ 100 Billion?

It now appears Facebook is getting closer to an IPO with a valuation at or, at least, near that $ 100 billion number. The IPO is expected to happen between April and June of 2012. This Wall Street Journal article points out the company wants to raise $ 10 billion. That would make it rather a large IPO by any standard.

The expected valuation?

$ 100 billion

Wall Street Journal: Facebook Targets Huge IPO

At $ 100 billion, Facebook will have nearly 4x the market valuation that Google (GOOG) had when it went public in 2004.

The Wall Street Journal article also says Facebook expects to have more than $ 4 billion in annual revenue once it goes public.

$ 4 billion revenue already. Facebook may turn out to be a terrific business. Whether it's a good investment is less clear at this point. It certainly will be one of the more interesting IPOs in a while. It's supposed to be profitable already but, for now, we don't have much detail on the financials. That will soon change. This Reuters article from back in September said net income in the 1st half of 2011 was almost $ 500 million (according to an anonymous source).

Previous post: Facebook's 1st Half Revenue Doubles

The SEC will require Facebook to make its financial information public once it has 500 shareholders. It's likely that will happen soon so it's a good bet we'll see more detailed financial information by April of next year.

If the Reuters article is correct, Facebook's annualized earnings should be $ 1 billion plus. Paying $ 100 billion for $ 1 billion plus of earning is obviously a very high multiple yet, considering the growth rate, who knows what the business is worth.

From this Bloomberg article:

"It's obviously a very steep valuation," said Schuster, whose firm invests in IPOs and oversees about $2.5 billion in assets. "They are realizing their window of opportunity, and they want to do it sooner rather than later."

On the surface, at least, Facebook's prospects are impressive. It looks to be potentially one heck of a potential franchise.

It may turn out to be a juggernaut for all I know. In time, it could even become clear why it's worth every penny of that $ 100 billion valuation. Yet, that doesn't necessarily make it a great stock to buy on a risk-adjusted basis.*

Investors don't put money at risk for the privilege of eventually getting their money back. It is about getting the best risk-adjusted return (preferably on something with a future prospects that are easily understood).

Price paid relative to value regulates risk. Higher uncertainty around valuation should logically require a greater discount, more of a margin of safety.

I think it is fair to say that starting at a $ 100 billion valuation takes away plenty of upside while offering quite a bit of downside if some dreams aren't realized.

With the information currently available and a relatively short track record, Facebook is obviously tough to value. We'll get more details and perspective on Facebook as the IPO approaches once the S-1 comes out.

It's worth noting that Apple (AAPL),who's not exactly growing slowly, has the earning capacity of roughly thirty Facebook's, yet an enterprise value (market cap - net cash and investments) that is less than 3x that $ 100 billion valuation.

Most companies when they go public do not start out as a large cap stock but it looks like Facebook's going to be an exception. I mean, quite a few rather solid, if less exciting, established business franchises could be bought for around $ 100 billion.

For example, the $ 100 billion could be used to buy all** shares of PepsiCo (PEP) and there'd still be a billion plus dollars remaining to start a nice venture fund.

Alternatively, that money could buy the three large U.S. railroads (CSX: CSX, Norfolk Southern: NSC, Union Pacific: UNP) not owned by Berkshire Hathaway (BRKa). After taking control of the railroads (and dealing with the inevitable anti-trust issues) that buyer would still have several billion dollars in the bank.

Easily enough pocket change to buy a full year's worth of production by Ferrari, Maserati, Aston Martin, and Lotus (hey, maybe even a Formula 1 team).

At least for me, those cars would be enough compensation for not being able to participate in the excitement of an IPO.

Besides, I'll take railroads over a social network. Even if the upside is more limited, in their current form the future prospects for railroads are easier to figure out and importantly, not too long ago, the price for some of them was right.

Adam

Related posts:
Facebook's 1st Half Revenue Doubles to $ 1.6 Billion
Is Facebook Worth $ 100 Billion?
Technology Stocks

* Near the expected valuation, the risk of negative returns is uncomfortably high if things go a bit less well than expected. Having said that, sustained high return on capital over 2 or 3 decades eventually does make an initially expensive looking investment make sense. In the very long run, results tend to be drawn like a magnet toward the return on capital earned by the business. I don't think I have any capacity to even roughly estimate Facebook's return on capital or its sustainability over such a long time horizon. Others may be able to.
** Of course, in the real world a premium to market value would need to be paid to buy all shares.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, November 25, 2011

Buffett on Europe: Investing While Uncertain - Part II

"The world's always uncertain. The world was uncertain on December 6th, 1941, we just didn't know it. The world was uncertain on October 18th, 1987, you know, we just didn't know it. The world was uncertain on September 10th, 2001, we just didn't know it." - Warren Buffett on CNBC

In this earlier post, I highlighted some of Warren Buffett's thought on Europe from an interview on CNBC.

During the interview, Buffett said he sees Europe as having a fundamental flaw.

In a separate CNBC interview, he also said that the current system they have is not working and even has doubts about the euro survival.

His response to this very serious and developing situation in Europe has been fairly straightforward...to buy stocks aggressively.

Buffett explained some of his thinking when it comes to making investments in this kind of uncertain environment:

"...there's always uncertainty. Now the question is, what do you do with your money? And if you—the one thing is if you leave it in your pocket, it'll become worth less—not worthless—worth less over time. That's certain—that's almost certain. You can put it in bonds and then you can get a certain 2 percent for 10 years and that's almost certain to be less than the decline in the purchasing power."

He later added...

"It's very interesting to me, if you own a farm and somebody said, you know, Italy's got problems. Do you sell your farm tomorrow? If you own a good business locally in Omaha and somebody says Italy's got problems tomorrow, do you sell your—do you sell your business?"

and...

 "...But for some reason, people think if they own wonderful businesses indirectly through stocks, they've got to make a decision every five minutes. So I do not think if Ben Bernanke comes up and whispers to me that he's going to do X, Y or Z tomorrow, I'm not going to change my view about what businesses I want to own."

Yes, Europe may not be a stable situation and it is not clear if the resolution will be orderly or not.

Yes, stocks will probably continue to go down if it goes badly over there.

Maybe, dramatically so.

Understandably, most do not want to watch something they just bought "cheap" get cheaper but, with stocks, that risk is always there and as Buffett points out above, it's not always the risks that are on the radar that cause the disruption.

Good businesses can withstand tough times and the best get stronger during the process even if price action gets really ugly. Many businesses during the last financial crisis made themselves stronger and intrinsically worth more. Share prices eventually follow.

The possibility or even likelihood that Europe will go very badly doesn't change whether part ownership of a good business makes sense when selling at the right discount to value. Margin of safety, as always, is key.

In the long run, it's generally the price paid relative to value, long-term compounding effects, low frictional costs, and the making of quality choices that dictates returns...not the macro stuff.

Later in the CNBC interview...

"I'm going to own these businesses five or 10 or 20 years from now and they'll be all kinds of good news and all kinds of bad news, but the good businesses, they do wonders for you over time."

None of this applies to money needed in the short or even medium run.

As the Europe situation develops, chances are shares in a good publicly traded business, even if bought with a margin of safety, will get cheaper for an extended period of time.

Yet, while near price action may head south, shares of a sound business (if judged correctly) is likely to be worth lots more in 10 or 20 years.

Why sell?

Besides, the lower prices just provide a chance to own more of the business at a discount.

As Buffett says, a farmer wouldn't sell productive farmland in Nebraska because Europe can't its act together. A true long-term shareowner will ignore the daily quotes and focus on things like: Can the business produce long-term high returns on capital? How substantial is the economic moat? Can it be built into something more robust over time? Is management honest and capable?

I think Buffett's belief that Europe may end up going very badly and the fact that he is buying so aggressively still baffles some. It shouldn't be surprising when considering how he has approached things over the years.

Shareowners need to worry about the quality of their business judgment not whether the stock market price will be up or down next week, month, or even year. I know this flies in the face of the many increasingly popular short-term trading strategies but the approach when applied well is a sound one.

In fact, maybe if more participants had a long-term value orientation, and fewer had a short-term technical/algorithmic orientation, maybe we'd have slightly less hyperactive markets.

Intrinsic value, doesn't fluctuate anything like the price action we see.

Those grounded first and foremost by value know it and their buy/sell behavior, if it made up a greater percent of volume, would likely be less about reacting to the next headline and gaming short-term price action. It certainly couldn't hurt though I realize markets will always have a tendency to be alternatively manic and depressed by nature.

The mood swings aren't going away.

Still, if participants with a long-term value bent were placing more of the votes in the short-term voting machine that is the stock market, it seems clear that the nature of price action as a whole would, to a meaningful degree, change. To me, it'd be a welcome culture change for capital markets that, considering entrenched interests, has just about zero chance of happening anytime soon.

The market still functions effectively as a weighing machine over the long haul but I think it is fair to say it need not be this hyperactive and dysfunctional in the short run.

There's plenty of room in the markets for speculation but the proportion matters.  There are many capable long-term investors but having a disproportionate number of participants with little more than a passing interest in things like intrinsic value can't be a good thing.

For some, intrinsic value probably seems little more than a quaint concept as they proceed to read the tea leaves via some chart that supposedly has a head-and shoulders-double-wishbone-cup-with-handle or whatever formation.

The capital markets primary reason for existing to effectively allocate capital. To me, there's little doubt it would function better if more of its participants were grounded more by making judgments of long run value less by gaming price action. That kind of change may create less opportunities for individual investors to profit from extreme mispricing, but the system would become less prone to capital misallocation.

It would also likely behave in a more stable manner which can't hurt business and consumer confidence.

Adam

Related posts:
Buffett Doubts Euro Survival, Views European Stocks Favorably
Buffett on Europe: Investing While Uncertain
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, November 24, 2011

Coca-Cola vs Alcoa: Full Business Cycle Earnings

From this Barron's interview with Mark Holowesko (formerly at Templeton and now manages over $ 2 billion at Holowesko Partners):

"At Templeton, we looked at earnings over a full business cycle..."

In the interview, Holowesko also says that some tend to look at earnings on a short-term basis. I think that frequently leads to misjudgments of intrinsic value. Sometimes, rather large ones. To gauge whether something is inexpensive, the more conservative approach is to use earnings over a full business cycle to estimate value then compare to the current share price.

So, in many cases (though, of course, not all), it's smart to look at earnings over a longer horizon. With this in mind, lets take a look at the business of Coca-Cola (KO) and Alcoa (AA).

For highly cyclical businesses, earnings need to be viewed over at least a full business cycle. Sometimes that's not even long enough. Consider the earnings of a cyclical business like Alcoa before, during, and right after the financial crisis:

Alcoa Earnings (millions)
2006       2007         2008          2009
2,246      2,562         (76)         (1,151)

Alcoa didn't return to profitability (barely) until 2010 and this year will have earnings that are still down by more than 50% compared to 2006. To make matters worse, its shares outstanding grew by nearly 30%.

The company continues to carry substantial debt.

For a business with mediocre at best economics, and vulnerable earnings during a recession, more modest use of debt is generally a good idea.

For financially sound businesses with very consistent earnings like Coca-Cola earnings do not necessarily need to be looked at over a full business cycle.

Here's an indication why it's far less necessary. In contrast to Alcoa, here's the earnings of Coca-Cola before, during, and right after the financial crisis:

Coca-Cola Earnings (millions)
2006       2007         2008         2009
5,080      5,981        5,807        6,824

Coca-Cola's earnings hardly missed a beat during the crisis. By 2009, Coca-Cola's earnings was 34% higher than 2006 and, of course, is much higher now (nearly $ 8.6 billion). Those earnings seem rather likely to increase, even if not every single year, nicely over time. Most importantly, it'll be accomplished at a high return on capital.

It mostly comes down to whether or not a business can generate attractive return on capital that, give or take, remains persistent going forward.

It comes down to whether or not a business possesses durable advantages.

There's nothing wrong with a little (or even more than a little) cyclicality if the return on capital generated over time, all risks considered, will remain sufficiently attractive.

For Coca-Cola this seems more than likely (even if, considering its sheer size, less so than the past).

For Alcoa, rather less so.

To understand the normalized earning power of many businesses, a single year of earnings is often insufficient. It all comes down to the quality of the business.

A full business cycle probably isn't even a long enough time frame for a business like Alcoa.

For one with persistently high earnings, a durable franchise, and great economics like Coca-Cola, the current year's earnings might work just fine.

Adam

Established a long position in Coca-Cola at much lower than recent prices
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, November 23, 2011

Netflix: Buys High, Sells Low

The chart in this Bespoke Investment Group post says it all. Check it out.

Buybacks work in situations where a financially sound (strong balance sheet, reliable free cash flow, high return on capital) business with a proven and durable franchise has its shares selling comfortably below intrinsic value.

Netflix (NFLX) hardly meets that criteria.

Since 2010, the company has bought back $ 410 million of stock.

The Netflix buyback in Q2 2011 occurred when shares sold in the $ 224-270/share range (the shares later briefly hit a bit over $ 300 in July). On average that's 60x what turns out to be, at least for the foreseeable future, peak earnings.

Buying back the stock at a high multiple of earnings is bad enough, but the mistake would be at least somewhat mitigated if this was a proven franchise with rapidly increasing earnings. As of now, it seems the opposite is true.

Earnings at Netflix is now widely expected to shrink dramatically so over the next year.

That's actually an understatement. In an SEC filing on Monday, an S-3 shelf registration, Netflix recently said that it expects to incur a net loss in 2012 due to flat revenue and an increase in international investment.

Buybacks, if executed for the right reason and at the right time, are an excellent way to enhance shareholder wealth.

Unfortunately, all too often, buybacks are done for the wrong reasons and at the wrong time.

To make matters worse, Netflix is now apparently in need of capital.

In that shelf registration, the company announced it was selling $200 million of common stock. In a separate filing, the company said it is also selling $200 million of convertible notes.

With shares now selling at $ 70.45, a more than 75% drop from the stock's peak, the company is providing as good an example as any in recent memory of poor capital allocation.

It would seem to be a buy high, sell low situation but who's to say the stock is selling at a low price? Low compared to the previous value maybe but not necessarily compared to value. For me, it's not clear at this time at all what the intrinsic value of Netflix is.

What's the durable competitive advantage of Netflix? Considering the dynamics of its competitive landscape I think that judging what Netflix is worth is a fairly speculative game. Obviously, others who have a handle on the company's prospects may think it is less so. Still, even if Netflix ends up a winner, on a risk adjusted basis, I can create a long list of better places to put money.

Some owners of other high multiple stocks may want to take note. There will be exceptions, of course, but most fast growing, dynamic, yet unproven franchises tend to have a large speculative premium in the stock price.

It certainly may work out but, if some of the dreams aren't realized, the sheer force of the core long run economics that most great franchises possess will not be there as a backstop for the owners.

Where possible, eliminate the chance for permanent loss of capital and the rest usually takes care of itself.

I'm sure it's no fun for a shareholder when the speculative premium that is implicit in a high multiple stock drains away. When that happens it leaves only what is of more explicit value (hopefully there is something) to support the stock price.

Of course, buy a good business with no speculative premium in the first place and you don't have to worry about for how long that premium will be sustainable.

Adam

Related post:
Amazon Sells Kindle Fire Below Cost
Technology Stocks

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, November 22, 2011

Buffett Doubts Euro Survival, Views European Stocks Favorably

Warren Buffett said the following about Europe yesterday to CNBC:

CNBC: Buffett Doubts Euro Survival

System, As Designed, Reveals Major Flaw
"Europe will either have to come closer together or there will have to be some other rearrangement because this system is not working," Buffett said in an interview.

Asked whether the union would survive this crisis, Buffett said: "That's in doubt now."

He went on to say...

"17 countries in the world gave up the right to issue bonds in their own currency. That is 100 degrees away from being able to issue them in your own currency like the United States," he said.

Fundamentally different. Buffett said he doesn't like the region's debt but thinks European stocks are attractive:

European Stocks
"...I left an order to buy one European stock which we will undoubtedly be buying today and we'll probably be buying it tomorrow and the next day and next week and next month," Buffett said.

"I can think of a dozen European stocks that are quite attractive."

So Buffett thinks Europe is in for some serious difficulty yet not only is he buying stocks...he's buying European stocks.

Prior post on European stocks: Europe, The Dividend Mecca

Lousy macro yet favorable micro opportunities isn't at all inconsistent. It does set up an interesting tension between the macro approaches to investing, seemingly ever more popular, and good old-fashioned micro-level stock analysis.

Macro vs Micro
The macro-environment seemed very favorable in the late 1990s yet that turned out to be a very difficult to make long-term investments. The reason was simple: prevailing price levels for many individual securities were too high relative to intrinsic value.

The opposite is also true.

Things can seem, and in fact be, rather ugly (and potentially unstable in not foreseeable near term ways) at the macro level but, since prices are low, there's many attractive individual investments that should do just fine on a total return basis over a longer cycle.

These days, things are certainly a mess at the macro level, seemingly in an endless way, yet there is no shortage of attractive individual stocks. So, in the right spots, the micro looks fine even if the macro problems will probably go on for years. In fact, stock prices will likely eventually get even cheaper with just awful price action at times.

None of this stops high quality well run business franchises from creating value over the long haul.

One approach is to try and time this and buy when some of the darker clouds seem to have passed.

Another approach is to focus on price versus value and accept that the quotes may look terrible for quite some time.

As far as the first approach, I have no idea how to time things consistently well and know of few, if any, successful long-term investors who do.

On the other hand, I know of many successful investors who've built a track record focusing on price versus value. The discipline of paying a discount to value consistently well may not be easy but, at least by comparison, is doable with some patience, homework, and sound judgment.

Some may wait for the micro and macro to be aligned but I'm guessing the world will rarely, if ever, be that way. A day when the "sun is shining" at the macro level while prices of individual securities are cheap doesn't seem compatible.

You buy quality farmland during an extended drought.

You buy shares of a quality business when the world feels or is uncertain.

The price of even the best stocks could and probably will go much lower as the worst possible outcomes play out in Europe or otherwise. There is always a level of uncertainty ahead, little of which we can know about with any conviction.

The buy orders usually have to begin being placed when an understandable quality business is selling at a discount yet the world and market price action seems rather less than serene (understandable is in the eye of the investor, of course).

Having said that, those who can't stomach the price action should certainly avoid buying.

At this recent event hosted by Bloomberg on November 17th, the CEO of Blackrock (BLK) Larry Fink tells a story about being at an event with Warren Buffett when the markets were down and in turmoil. He said:

Fink Discusses Warren Buffett's Investment Strategy

"I was with Warren one time when the markets were absolutely falling out of bed, and he got up 2 or 3 times and was buying more stocks. So we all envy and look at Warren Buffett as a great investor, yet most people have no inclination to invest like him. We should be more like Buffett and think about how we can invest for a long cycle solution and if you do that you're going to have higher than normalized market returns." - Larry Fink

I understand why many try to wait until there is more certainty in the world. I mean, loss aversion is a powerful force. The fact is, it's unwise for an investor to buy unless he or she has a high level of conviction in the business they are buying shares in and the discount to plain value seems obvious.

Yet, when those favorable circumstances are in place (ie. stock seems clearly cheap and conviction level is high) but the investor holds off on buying out of concern for the very real possibility that stock prices will temporarily go lower, it can be a real mistake.

The risk of the stock going down temporarily usually ends up, understandably, being front of mind. Yet, what happens if the stock rallies and the chance to own enough shares at a discount disappears?

That's a separate but very real risk. It's certainly okay if a stock one lacks a strong conviction in "gets away" as it rallies to a higher price (a price that no longer provides an acceptable margin of safety).

On the other hand, miss the chance to own discounted shares of something that one has a strong conviction in due to fear of a temporary drop in price eventually cuts into long-term returns.

These errors of omission are expensive though most of us focus on the opposite. It inevitably happens to even the very best investors. Buffett has said that some of his biggest investing mistakes were errors of omission.

There are many seemingly inexpensive stocks right now but it's not possible to fully understand them all. Some stocks take years to figure out and even longer for a very good price to come along.

Shares of an understandable business, in terms of long-term risks and opportunities, selling at a plain discount to value tend to not come along all that often. At least that is the case for me.

With that in mind, if shares of some business I feel strongly about as a long-term investment is finally being offered by Mr. Market at a large enough discount, it's time to decisively buy a meaningful amount. After that the shares will often proceed to get even cheaper. That's a good thing in the long run.

Successful investing starts with buying an asset at a discount to estimated value and, if judged correctly, benefiting from the compounded long-term effects (5 or 10 years...preferably more) of what the asset itself produces. The near or medium term price action is only of interest if it provides an opportunity for more shares to be purchased by the owners at a discount from time to time (buybacks included).

Anyone primarily interested in near term price action will probably find most or all of this to be academic at best.

Adam

Related posts:
Buffett on Europe: Investing While Uncertain - Part II
Buffett on Europe: Investing While Uncertain
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, November 21, 2011

Klarman's Baupost Group 3rd Quarter 2011 13F-HR: Bullish On HP?

At the very least, regulatory filings this past quarter reveal no shortage of investors who are building meaningful positions in large capitalization technology stocks.

This article in Institutional Investor this past Friday highlights that Ralph Whitworth of Relational Investors LLC now owns 1 percent of Hewlett-Packard (HPQ). He also secured a board seat.

The article also points out Baupost's Seth Klarman disclosed a substantial position in HP.

Baupost has assets under management north of $ 20 billion. So while this HP position may make up an awful large percentage of the stocks Baupost owns that trade in the U.S., it's actually a relatively small part of the whole. This Bloomberg Businessweek article says Baupost had $ 3 billion in U.S. stocks on September 30th.

So that $ 3 billion in stocks make up only a small portion of the portfolio.

From that point of view it reveals less but still a meaningful move.

Here's the top five Baupost equity positions that trade on a U.S. exchange:

Top Five Positions
BP ADS (BP): 16.4% of the portfolio. More than doubled the position (increased position ~150%).
Hewlett Packard (HPQ): 15.4% of the total portfolio. New position.
ViaSat (VSAT): 11.6% of the total portfolio. Minor increase to position size (~ 4%).
News Corp. (NWSA): 10.8% of the total portfolio. Slight increase to position (~10%)
Microsoft (MSFT): 9.9% of the total portfolio. No Change.

The portfolio is, not unlike Berkshire Hathaway's (BRKa), very concentrated with roughly 50% in the top five.

Berkshire's top five is more like 75% as of the latest filing.

There's been a notable number of large capitalization technology stock purchases by those not normally associated with making such investments. Some for the first time ever. Most notable, of course, is Warren Buffett.

Last week we learned he made a major purchase (nearly $ 11 billion) of IBM (IBM) and a much smaller (~ $ 200 million) investment in Intel (INTC).

Berkshire Hathaway's 3rd Quarter 2011 13F-HR

Two stocks not too long ago many thought Buffett would never have an interest in.

What has suddenly put these on the radar? Price relative to value, of course. When a perceived discount to a conservative estimate of intrinsic value exists, value-oriented investors usually begin to take notice. What seems an uninteresting alternative at the higher price, considering the specific risks involved, becomes front and center.

Paying a low price relative to well-judged value (conservatively calculated, of course) may help regulate investment risk, but reveals nothing about the likely near-term or even somewhat longer-term price action of a stock.

Adam

Baupost Group 3rd Quarter 2011 13F-HR

Long positions in HPQ, BP, MSFT, and INTC
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Friday, November 18, 2011

Buffett on "The Institutional Imperative": Berkshire Shareholder Letter Highlights

Some of my previous posts have made reference to what Warren Buffett calls "the institutional imperative". In a nutshell, it's the tendency for organizations to:

- resist changes in direction;
- make less than optimal use of corporate funds;
- support even very foolish initiatives;
- imitate, at times rather unwisely, the actions of peer companies.

As Buffett explains below, the "troops" will all too often just fall in line with the folly.

In fact, he explains that they will even provide the supporting justification for ill-advised initiatives simply because it has become the focus of their business leader.

An investor won't necessarily see the impact of this behavior in the short run numbers but, over the long haul, it matters a lot when it comes to the creation per share intrinsic value for owners.

Tough to quantify. Very real.

The excerpt below, from the Mistakes of the First Twenty-five Years section of the 1989 Berkshire Hathaway (BRKa) shareholder letter, provides a more complete explanation of what Buffett means by "the institutional imperative":

"My most surprising discovery: the overwhelming importance in business of an unseen force that we might call 'the institutional imperative.' In business school, I was given no hint of the imperative's existence and I did not intuitively understand it when I entered the business world. I thought then that decent, intelligent, and experienced managers would automatically make rational business decisions. But I learned over time that isn't so. Instead, rationality frequently wilts when the institutional imperative comes into play.

For example: (1) As if governed by Newton's First Law of Motion, an institution will resist any change in its current direction; (2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops; and (4) The behavior of peer companies, whether they are expanding, acquiring, setting executive compensation or whatever, will be mindlessly imitated.

Institutional dynamics, not venality or stupidity, set businesses on these courses, which are too often misguided. After making some expensive mistakes because I ignored the power of the imperative, I have tried to organize and manage Berkshire in ways that minimize its influence. Furthermore, Charlie and I have attempted to concentrate our investments in companies that appear alert to the problem."

It's a big factor in many large -- and sometimes not so large -- organizations. The problem is it's not always visible to the investor.

Yet it's still worth watching for clues.

Occasionally, the actions of senior management will reveal a whole lot over time.

Independent minded business leaders who build organizations that are less susceptible to the "the institutional imperative" are out there. Even if hard to gauge from the outside, it's still worth attempting to figure out who "gets it" and are willing to take appropriate action; it's worth figuring out who understands the damage it does and how to create an environment that mitigates the tendency.

Some certainly do.

Capable leaders of good businesses can end up producing lots of additional wealth for owners by creating the right kind of corporate culture.

Adam

Long position in BRKb

Related post:
Buffett: A Portrait of Business Discipline

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Thursday, November 17, 2011

The Bond Market Rules

Do capital markets serve us or vice versa? This recent Barron's article by Thomas Donlan provides an unequivocal point of view when it comes to the bond market:

Knock, Knock: Open the gates of Rome to the market

"Unrecognized as saviors, the bond vigilantes are demanding the keys to the Eternal City. If the Italian people are very lucky and very wise, they will allow themselves to be ruled by the bond market."

Reminds me of what James Carville once said:

"I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody." - James Carville (Wall Street Journal, February 1993)

Consider that Carville said the above well before the vast world of what is essentially unregulated insurance, the credit default swap (CDS), came into prominence.

The world CDS is, in effect, an immense casino where you can bet against someone's debt (profit from default) without being required to have an insurable interest.

Now, consider that the insurable interest doctrine is a fundamental concept in insurance that came about long ago for some very good reasons learned the hard way. It originated in English statutes. The intention of these statutes was to...

"...remove insurance contracts from the environment of gambling and the misconduct commonly associated with one having the ability to profit from another's loss." - From the Origin Of The Insurable Interest Doctrine

It's, in part, about eliminating the ability to buy insurance on another's property. Basically, the aim is to remove any incentives a speculator may have to destroy or reduce the value of another person or entity's assets.

Well, the CDS market pretty much circumvents this doctrine.

The excerpt below is from a paper that compares an 18th century speculator to a 21st century hedge fund manager.

The 18th century speculator buys insurance on a British cargo ship.

The 21st century hedge fund manager buys credit default swaps.

Insurance and Credit Default Swaps: Should Like Things Be Treated Alike?

"Compare the following hypotheticals:

An 18th century speculator buys insurance on a British cargo ship in which he has no interest. The speculator then sends a message to his cousin in Paris, asking the cousin to inform the French fleet of the ship's schedule. A French frigate uses the information to sink the British vessel. The speculator collects on his insurance contract. To mitigate this danger, the insured interest doctrine was created to keep the speculator from profiting on his insurance contract.

A 21st century hedge fund manager buys millions of dollars in CDSs that will pay off only if company (x) declares bankruptcy. The hedge fund manager then organizes the short-term purchase of creditor voting rights as the embattled company (x) attempts to borrow money to avert Chapter 11. The hedge fund votes against allowing further borrowing and company (x) is forced to declare bankruptcy.

The CDS bet pays off and the hedge fund manager finds herself with a substantial return. In terms of the moral hazard to be averted, the second hypothetical is no different from the first as both create new risk through contract."

Later in the paper...

"...CDS traders and their attorneys have worked hard to distinguish their new financial product from insurance to avoid stringent regulatory insurance regimes."

Someone that buys a CDS, yet doesn't own the underlying debt, has an interest in things going badly. More from the paper:

"...CDS contracts, in [Professor Frank] Partnoy's words, might create incentives to destroy value by allowing profit to be born from loss."

Might? Nicely understated. Sometimes things in combination form their own reality. Maybe a few misleading statements get made or rumors get spread. More buyers come along and the price of the CDS goes up in value (the CDS markets are not the most liquid). That move in price is taken as an indicator of credit stress and creates a headline.

This stuff feeds on itself.

With enough force, emotion, money, and clever use of the media it can, in fact, do real damage. There's certainly no shortage of powerful media tools available these days.

Does it feed on itself to the point where a bank run of sorts is precipitated? Maybe not, but who knows?

More than occasional misconduct seems inevitable without, among many other things*, of course, something like an insurable interest requirement in place.

From a historical perspective, England provided leadership when it comes to the insurable interest doctrine. The doctrine came about in the 1700s under George II and III after seeing the kinds of bad behavior that results without it. They had learned the hard way from vast experience that lack of such a doctrine creates moral hazard. A system that allows someone buy insurance on another's property generally serves the world poorly.

It's a doctrine that has served civilization quite well I might add for a very long time.

"The English Statutes of George II and George III form the fundamental principles of the insurable interest doctrine by requiring owners of property and life insurance to have an 'interest' in the subject matter of those contracts." - From the Origin Of The Insurable Interest Doctrine

The arguments against treating CDS as insurance seem to deliberately ignore the inevitable creation of moral hazard. The disregard for the purpose of things like insured interest is disappointing but not surprising. It would be baffling if it weren't fairly clear that plenty with more than a little influence have a vested interest in the status quo.

No doubt these contracts serve some individuals or organizations very well but as constructed now it's potentially at great cost to the rest. Many will argue, especially true believers that markets always know best, things like CDS and bond vigilantes play a vital role in forcing the target governments, banks, and businesses to get their house in order. That can be a potential very real plus. The problem is that view ignores the other sharp side of what is a two-edged sword. Without more safeguards and a more proper balance, the current system as designed can make, if abused, a serious problem into an emergency with costly consequences.

Considering the immense size and potential destructiveness of the CDS market in its current form, I think it is more than fair to say that it, along with some other aspects of increases to system complexity and interconnectedness, needs to be reigned in to some extent. From this paper by James Rickards:

"Despite obvious advantages in terms of global capital mobility facilitating productivity and the utilization of labor on an unprecedented scale, there are hidden dangers and second-order costs embedded in the sheer scale and complexity of the system. These costs have begun to be realized in the financial crisis that began in late 2007 and have continued until this writing and will continue beyond."

There are very real structural problems related to too much global leverage.

There's no question.

Yet, the size, complexity, and interconnectedness of the existing financial system can also add instability that turns real and serious economic problems unexpectedly and unpredictably into even bigger ones.

It seems to me that the advent and existence of the CDS market, among other financial "innovations", can convert what are merely serious problems (that historically would otherwise likely be solved over time even if done in a messy and slow fashion) into crisis or worse because of the sheer scale, complexity, and interconnectedness now involved.

Financial weapons of mass destruction, indeed.

Adam

Related post:
Sinking Seaworthy Ships

* Among those other things less leverage is a good place to start. Also, more limitations on the use of derivatives (which is, of course, a huge source of hidden leverage and hard to measure risk) or at least a clearinghouse of some kind for transparency (increasingly banks are clearing credit and interest rate derivatives through central counterparties). The list of safeguards and limits that seem needed to assure system stability goes on. The risks associated with the scale, complexity, and interconnectedness of the financial system are clearly not well enough understood. I'm guessing, in time, we'll learn much more has to be done to protect the system against the risk of instability and catastrophic collapse. A system this complex ultimately, when under stress, cannot be expected to behave predictably in any meaningful way. Limits and safeguards that protect the system (not the participants) seem inevitable. The question seems to be whether they'll be done proactively or not.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Wednesday, November 16, 2011

Buffett on Europe: Investing While Uncertain

On CNBC this past Monday, Warren Buffett said what may be Europe's fundamental flaw "is that they can't print money. And when you have a loss of confidence, that begins a run, which has occurred to some degree on both sovereign debt and banks over there." 

He also said what resolved the mess in 2008 was "belief that the authorities would do whatever it took, and we did believe that, and it led us out. But it's not clear who can say, 'We'll do whatever it takes'."

Buffett is very concerned about Europe yet that has not throttled him when it comes to making investments.

The fact is he has been making purchases hand over fist, certainly more so than any time in recent (and maybe even not so recent) memory.

The most recent 13F-HR, along with the $ 20 billion plus of investments that he made last quarter, is pretty clear evidence that this Europe thing isn't slowing him down on the investment front.

So how can his view of Europe and aggressive buying coexist?

Some might expect he'd be a net seller with this view that Europe could end up in some kind of free fall.

Not at all.

Continuing with Buffett's views on Europe.

Buffett said it "used to be when you had a run on banks, you know, that the tellers started paying out slowly and they piled up gold in the teller window. But now you do it electronically..."

Then later:

"It's very, very tough to stop a run. It takes—it takes a belief, widespread belief, that the people in authority will do whatever it takes to stop it and they have the ability..."

He went on to say that time works against you when "the world is seeing the line getting a little longer."

In these situations, people end up acting with emotion and the problem is emotion becomes reality. Then he added...

"...Europe's got all kinds of strengths. I mean, Europe is not going to go away. Ten years from now we will be selling more goods and buying—to Europe and buying more goods from Europe, and they will have more GDP per capita. But getting from here to there may be a problem."

Much later in the conversation that morning on CNBC, he explained how he handles all this uncertainty and how it affects what he is buying or selling. Buffett said there is always uncertainty but the question is "what do you do with your money?"

More on investing with uncertainty in a follow up post.

Adam

Related posts:
Buffett on Europe: Investing While Uncertain - Part II
Buffett Doubts Euro Survival, Views European Stocks Favorably
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Tuesday, November 15, 2011

Berkshire Hathaway 3rd Quarter 2011 13F-HR

The Berkshire Hathaway (BRKa3rd Quarter 2011 13F-HR was released yesterday.

For comparison purposes here's the 2nd Quarter 2011 13F-HR. This quarter some new positions were added while continuing to build upon several existing positions.

There also was a bit of selling.

Here is a post that summarizes changes made in the previous Berkshire Hathaway 13F-HR.

Here's what changed during the quarter:

Equities Purchased
New positions:
IBM (IBM): Bought 57.3 million shares*, value ~$ 10.7 billion
Intel (INTC): 9.3 million shares, $ 230 million
CVS (CVS): 5.6 million shares, $ 220 million
Visa, Inc. (V): 2.3 million shares, $ 215 million
General Dynamics (GD): 3.1 million shares, $ 200 million
DirecTV (DTV): 4.3 million shares, $ 194 million

In my previous 13F-HR summary, I mentioned that some of the confidential or "mystery purchase(s)" made that quarter must be relatively significant in size. I made that comment back then because there was clearly a large gap between the dollar value of equities purchased per Berkshire's 2nd Quarter 10-Q cash flow statement versus what was disclosed in the 13F-HR.

We obviously now know what that gap was at least mostly all about:

IBM

Buffett said,in this CNBC interview yesterday, the quarterly filing will probably only show 57 million shares of IBM but more has been purchased since the end of the quarter. The total is now more like 64 million according to Mr. Buffett.

Buffett on IBM: Berkshire Buys Big Blue

From time to time, the SEC allows Berkshire Hathaway to keep certain moves in the portfolio confidential. Permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.

With Buffett's disclosure on CNBC yesterday, we learned that Berkshire has been purchasing IBM since March and the SEC giving permission to keep it confidential until yesterday.

The 3rd Quarter 13F-HR says: "Confidential information has been omitted from the Form 13F-HR and filed separately with the Commission." 
(Update: It turns out to not be the case. In an amended 3rd Quarter 13F-HR filing, Berkshire removed a reference to being granted permission from the Securities and Exchange Commission to omit some confidential information.)

Added to Existing Positions:
Wells Fargo (WFC): Bought 9.0 million shares, ~$ 228 million (2.6% increase)
Dollar General (DG): 3.0 million shares, $ 116 million (200% increase)
Verisk (VRSK): 2.1 million shares, $ 78 million (100% increase)
(an amended 13F-HR later filed by Berkshire revealed no shares of VRSK were added)**

Equities Sold
Reduced Positions:
A little less than 10 million shares of Kraft (KFT) was sold (a 10% decrease). Remaining shares are now worth ~ $3.2 billion and the stocks is no longer a top five position.

Approximately 4.5 million shares of Johnson & Johnson (JNJ) were sold (a 12% decrease). Remaining shares are worth $2.4 billion.

No positions were sold outright.

Portfolio Summary***
After the changes, Berkshire Hathaway's stock portfolio is made up of ~ 36% consumer goods, 31% financials, 17% technology, 6% consumer services, and 4% healthcare. The remainder is primarily spread across industrials and energy.

1. Coca-Cola (KO) = $ 13.6 billion
2. IBM (IBM) = $ 12.0 billion
3. Wells Fargo (WFC) = $ 9.0 billion
4. American Express (AXP) = $ 7.5 billion
5. Procter and Gamble (PG) = $ 4.9 billion

As is almost always the case, it's very concentrated with the top five making up often 60-70 percent and, at times, even more of the equity portfolio.

Many of these purchase(s), especially the smaller ones, could at least in part be those of Todd Combs. Initially, Combs is expected to manage just $ 2-3 billion of the Berkshire equity portfolio.

As of the last 10-Q (the best view available until the annual report comes out), the combined value of the Berkshire portfolio including the above equities plus fixed maturity securities and other investments is more than $ 120 billion (excluding cash).

That portfolio, of course, excludes all the operating businesses Berkshire owns outright. Here are some examples of the non-insurance businesses: MidAmerican Energy, Burlington Northern Santa Fe, McLane Company, The Marmon Group, Shaw Industries, Benjamin Moore, Johns Manville, Acme Building, MiTek, Fruit of the Loom, Russell Athletic Apparel, NetJets, Nebraska Furniture Mart, See's Candies, Dairy Queen, The Pampered Chef, Business Wire, Iscar Metalworking, and Lubrizol among others.

In addition, the insurance businesses (BH Reinsurance, General Re, GEICO etc.) owned by Berkshire have naturally provided plenty of "float" for their investments over time and continue to do so.

See page 106 of the annual report for a full list of Berkshire's businesses.

The earning power of these combined businesses is easily north of $ 10 billion/year.

In addition to the nearly $ 7 billion of equity investments last quarter, roughly $ 14 billion of Berkshire's cash was used to close the Lubrizol transaction and the Bank of America (BAC) preferred shares.

After all these moves, there remained $ 35 billion or so in cash on Berkshire's balance sheet at the end of the 3rd quarter. With that pile of cash growing at a rapid rate, there remains no shortage of money to put to work at Berkshire.

Adam

Long positions in BRKb, KO, WFC, AXP, PG, KFT, and JNJ established at lower than recent market prices. Established long position in BAC at higher prices.

* Using the 57.3 million shares as of the end of 3Q. Because of Buffett's disclosure yesterday on CNBC, we know that additional shares were purchased since then. I've included the total of 64 million shares in the calculation of IBM's value when I list the top five holdings. Current value is based upon yesterday's closing price (as it is for the calculation of value for all other holdings). Obviously, the actual price paid for the shares during the quarter could be very different.
** Initially reported in the 13F but later corrected in an amended 13F. No new shares of Verisk were actually added. Check out this Wall Street Journal article for more information. In the amended filing, Berkshire also removed a reference to being granted permission from the Securities and Exchange Commission to omit some confidential information.
*** Berkshire Hathaway's holdings of ADRs are included in the 13F-HR. What is not included are the shares listed on exchanges outside of the United States. The status of those shares (BYD, POSCO, Sanofi, Tesco etc.) are updated in the annual letter.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Monday, November 14, 2011

Buffett on IBM: Berkshire Buys "Big Blue"

This morning on CNBC, Warren Buffett revealed that Berkshire Hathaway (BRKa) had accumulated a large stake in IBM (IBM).

The sheer size of the purchase is, in itself, news. That Buffett is buying a technology company at some scale even more so.

How things seem to have changed.

It's clear that the valuation landscape of some larger capitalization technology franchises is nothing like a decade ago.

Many these days are very inexpensive with quite a few even selling at price to earnings ratios in the single digits.

According to Buffett, the number of shares of IBM bought by Berkshire was around 64 million at an average price of ~$ 170/share.

So the actual amount invested in IBM looks to be somewhat less than $ 11 billion.

As of Friday's close, the share price of IBM was $ 187.38/share meaning, at this time, the shares are now worth more like $ 12 billion.

Even considering Berkshire's size, this is certainly not at all a small stock purchase.

To put it in perspective, at Friday's closing price here is how the new stake in IBM compares to the size of Berkshire's three other large holdings*:

Coca-Cola (KO): $ 13.6 Billion
IBM (IBM): $ 12.0 Billion
Wells Fargo (WFC): $ 9.0 Billion
American Express (AXP): $ 7.6 Billion

Those 4 stocks now make up roughly two thirds of the entire $ 60 billion plus Berkshire Hathaway domestic equity portfolio.

It will be interesting to learn over time what Buffett views as IBM's durable competitive advantage(s).

Historically, Buffett has made it clear why he avoids things like technology businesses. His preference is for businesses and industries with little change.

On many past occasions, Buffett has explained how difficult he finds it to gauge the economic durability of any business that is in a fast-changing industry. An example:

"...you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek." - Warren Buffett in the 1996 Berkshire Hathaway Shareholder Letter

What's the economic moat? What is it going to look like in ten years or so? Will it grow or shrink? By their nature, tech businesses often reside in a rapidly changing and competitive industry environment so it is hard to gauge these things.

Now, the IBM of today is nothing like old-school IBM. The company's business model today places more emphasis on providing higher margin software and service to IT departments, less on the brutally competitive lower margin hardware business of its past.

Their current way of doing business would seem to offer more flexibility, utilizing IBM's expertise to adapt to changes in the technology landscape. Quite a bit less vulnerable to technology shifts, more about being a trusted source that helps IT departments do their job better.

In the CNBC interview, Buffett did say "I've probably read the annual report of IBM every year for 50 years" and that this year he "got a different slant on it."

Buffett also said he checked with the IT departments of the company's Berkshire owns:

"...to see how their IT departments functioned and why they made the decisions they made. I just came away with a different view of the position that IBM holds within IT departments and why they hold it and the stickiness and a whole bunch of things."

So there is some form of a durable moat at work here. Hearing a more comprehensive explanation at some point of how Buffett sees IBM meeting the "certainty we seek" threshold noted above will be of some interest.

He was also complimentary of IBM's shareholder friendliness. As an example, the company has reduced share count substantially since the end of 2006. Shares outstanding was lowered from over 1.5 billion to 1.2 billion since the end of that year.

IBM currently sells for slightly more than 14x earnings so, while not expensive, not nearly as cheap as some other large cap technology companies.

During the interview, he was questioned by Joe Kernen of CNBC on why the purchase of shares in IBM was at what at least seemed a higher price. In other words, not expensive but not really a bargain, either. There were, in fact, many chances to buy it much cheaper not long ago. His response:

"We bought railroads on highs..."

and

"...I bought control of GEICO at its all-time high."

As investments, in both cases, these two examples worked out more than okay for Berkshire's investors.

To an extent, Buffett did equate coming to the IBM party late, so to speak, with how his views changed on the railroads. He said that railroads "were something I should have spotted years earlier" that finally "just hit me between the eyes and it was there."

The impression, somewhat understandably, seems to be that Buffett has some unique ability to buy things when they are hitting at or near new lows or that he is often shrewd about getting exposed to an idea early. A quick check of history reveals otherwise.

Sound judgement of value**, how it may change over time, and the discipline to buy shares of a good business when selling at a comfortable discount is what has been and always will be what is crucial.

Being early on a good idea and/or buying something near all-time lows is tough to do consistently, even if a nice bonus when it happens, but fortunately is also not a required skill to produce above average long-term returns.

The aforementioned sound judgment of value and buying discipline certainly is required.

The difficult part, at least for many, is the ability to deal with short or medium term losses on paper. Now, if value has been judged too high or too much was paid, there's probably nothing "paper" about those losses.

Unless luck intervenes odds are they're real and permanent.

It's not at all unlikely that a cheap stock will at least temporarily even get cheaper. So sometimes those paper losses will persist for quite a while. Yet, as long as current value and likely increases to value has been judged reasonably well, that stubbornly low price is actually a net benefit to long-term owners.

The reason? Some shareholders, likely those with less patience or conviction annoyed by the lousy stock price action, end up selling shares below their intrinsic value (whether a loss to them individually or not) so they can move on to something they feel has a quicker and certainly more near-term explicit upside. For some, the game is first and foremost price action not price versus value.

A time horizon that is less than 3 to 5 years, never mind 3 to 5 minutes, doesn't work. The process plays out over many years, preferably a decade or more, and in a hyperactive-attention-deficit oriented market, this whole approach probably seems to make little sense.

Seems being the operative word because the pure long run arithmetic involved here is actually relatively simple to understand.

The shares being sold below intrinsic value, mostly by the impatient and annoyed, end up either repurchased (if management is doing its job), in the hands of new value-oriented buyers, or in the hands of long-term holders who'd like to accumulate more of the business while still cheap. The portion of profits sold for less than full value ends up directly benefiting long-term owners, of course.

That benefit, on a compounded basis over a long enough time horizon is not small.

Of course, substantially misjudge the value, how that value may change over time, or pay a large premium to value and the outcome will probably be much less favorable. Permanent capital loss becomes more likely when value is misjudged and/or an investor pays too much.

Buffett began to buy IBM's shares back in March of this year but, since sometimes the SEC allows Berkshire's buying to be kept confidential, the position wasn't known until it was disclosed today. Permission is granted by the SEC when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.

Adam

With the exception of IBM, I am long each of the stocks in this post.

Related posts:

Technology Stocks
Bufett: Severe Change, Exceptional Returns Don't Mix
Buffett on Competitive Dynamics
Buffett on Space Exploration

* Based upon the 2nd Quarter Berkshire Hathaway 13F-HR (the latest available equity portfolio snapshot). The 3rd Quarter 13F-HR should be released later today. 

** Value driven by the size of the economic moat/sustainability of its competitive advantage, high return on capital, a management culture that tends to allocate capital wisely etc.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
 
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